4 14 Oligopoly PART III MARKET IMPERFECTIONS AND THE ROLE OF GOVERNMENTCHAPTER OUTLINEMarket Structure in an OligopolyOligopoly ModelsThe Collusion ModelThe Price-Leadership ModelThe Cournot ModelGame TheoryRepeated GamesA Game with Many Players: Collective Action Can Be Blocked by a Prisoner’s DilemmaOligopoly and Economic PerformanceIndustrial Concentration and Technological ChangeThe Role of GovernmentRegulation of MergersA Proper Role?

5 Market Structure in an Oligopolyoligopoly A form of industry (market) structure characterized by a few dominant firms. Products may be homogenous or differentiated.Market Structure in an OligopolyFive Forces model A model developed by Michael Porter that helps us understand the five competitive forces that determine the level of competition and profitability in an industry.

7 Market Structure in an OligopolyTABLE Percentage of Value of Shipments Accounted for by the Largest Firms in High-Concentration Industries, 2002Industry DesignationFour Largest FirmsEight Largest FirmsNumber Of FirmsPrimary copper9910010Cigarettes9515Household laundry equipment9313Cellulosic man-made fiber8Breweries9094344Electric lamp bulbs8957Household refrigerators and freezers8518Small arms ammunition83109Cereal breakfast foods8245Motor vehicles8191308Source: U.S. Department of Commerce, Bureau of the Census, 2002 Economic Census, Concentration Ratios: ECO2-315R-1, May 2006.

8 Market Structure in an Oligopolyconcentration ratio The share of industry output in sales or employment accounted for by the top firms.contestable markets Markets in which entry and exit are easy.

9 Why are Record Labels Losing Key Stars like Madonna?Market Structure in an OligopolyWhy are Record Labels Losing Key Stars like Madonna?Madonna (and the Internet) Disrupts Another BusinessWall Street Journal

10 Oligopoly Models The Collusion Modelcartel A group of firms that gets together and makes joint price and output decisions to maximize joint profits.tacit collusion Collusion occurs when price- and quantity-fixing agreements among producers are explicit. Tacit collusion occurs when such agreements are implicit.

11 Oligopoly Models The Price-Leadership Modelprice leadership A form of oligopoly in which one dominant firm sets prices and all the smaller firms in the industry follow its pricing policy.The Cournot Modelduopoly A two-firm oligopoly.

12 Oligopoly Models The Cournot Model FIGURE Graphical Depiction of the Cournot ModelThe left graph shows a profit-maximizing output of 2,000 units for a monopolist with marginal cost of $2.The right graph shows output of 1, units each for two duopolists with the same marginal cost of $2, facing the same demand curve.Total industry output increases as we go from the monopolist to the Cournot duopolists, but it does not rise as high as the competitive output (here 4,000 units).

13 When a group of profit-maximizing oligopolists colludes on price and output, the result is exactly the same as:a. The perfectly competitive case.b. The monopolistically competitive case.c. The monopoly case.d. None of the above. The collusion model yields results is unlike any other market structure.

14 When a group of profit-maximizing oligopolists colludes on price and output, the result is exactly the same as:a. The perfectly competitive case.b. The monopolistically competitive case.c. The monopoly case.d. None of the above. The collusion model yields results is unlike any other market structure.

15 Game Theorygame theory Analyzes the choices made by rival firms, people, and even governments when they are trying to maximize their own well-being while anticipating and reacting to the actions of others in their environment.dominant strategy In game theory, a strategy that is best no matter what the opposition does.

16 Game Theory  FIGURE 14.3 Payoff Matrix for Advertising GameBoth players have a dominant strategy. If B does not advertise, A will because $75,000 beats $50,000. If B does advertise, A will also advertise because a profit of $10,000 beats a loss of $25,000. A will advertise regardless of what B does. Similarly, B will advertise regardless of what A does. If A does not advertise, B will because $75,000 beats $50,000. If A does advertise, B will too because a $10,000 profit beats a loss of $25,000.

17 Game Theoryprisoners’ dilemma A game in which the players are prevented from cooperating and in which each has a dominant strategy that leaves them both worse off than if they could cooperate.

18 Game Theory  FIGURE 14.4 The Prisoners’ DilemmaBoth players have a dominant strategy and will confess. If Rocky does not confess, Ginger will because going free beats a year in jail. Similarly, if Rocky does confess, Ginger will confess because 5 years in the slammer is better than 7. Rocky has the same set of choices. If Ginger does not confess, Rocky will because going free beats a year in jail. Similarly, if Ginger does confess, Rocky also will confess because 5 years in the slammer is better than 7. Both will confess regardless of what the other does.

19 Game TheoryNash equilibrium In game theory, the result of all players’ playing their best strategy given what their competitors are doing.maximin strategy In game theory, a strategy chosen to maximize the minimum gain that can be earned.

20 The prisoners’ dilemma yields the following outcome:a. Both criminals would be better off confessing, but they choose not to confess.b. Both criminals would be better off not confessing, but they choose to confess.c. If both criminals confess, they both get the most lenient sentence possible.d. When both criminals confess, they get the maximum sentence.e. Whether the criminals confess or not, they get the maximum sentence.

21 The prisoners’ dilemma yields the following outcome:a. Both criminals would be better off confessing, but they choose not to confess.b. Both criminals would be better off not confessing, but they choose to confess.c. If both criminals confess, they both get the most lenient sentence possible.d. When both criminals confess, they get the maximum sentence.e. Whether the criminals confess or not, they get the maximum sentence.

22 Game Theory FIGURE Payoff Matrixes for Left/Right–Top/Bottom StrategiesIn the original game (a), C does not have a dominant strategy. If D plays left, C plays top; if D plays right, C plays bottom. D, on the other hand, does have a dominant strategy: D will play right regardless of what C does. If C believes that D is rational, C will predict that D will play right. If C concludes that D will play right, C will play bottom. The result is a Nash equilibrium because each player is doing the best that it can given what the other is doing.In the new game (b), C had better be very sure that D will play right because if D plays left and C plays bottom, C is in big trouble, losing $10,000. C will probably play top to minimize the potential loss if the probability of D’s choosing left is at all significant.

23 Game Theory Repeated Gamestit-for-tat strategy A repeated game strategy inwhich a player responds in kind to an opponent’s play. FIGURE Payoff Matrix for Airline GameIn a single play, both British Airways (BA) and Lufthansa Airlines (LA) have dominant strategies. If LA prices at $600, BA will price at $400 because $1.6 million beats $1.2 million. If, on the other hand, LA prices at $400, BA will again choose to price at $400 because $800,000 beats zero. Similarly, LA will choose to price at $400 regardless of which strategy BA Chooses.

24 Price Fixing or Price Competition?Game TheoryA Game with Many Players: Collective Action Can Be Blocked by a Prisoner’s DilemmaPrice Fixing or Price Competition?Suit Accuses Car Rental Firms of Price-FixingLos Angeles Times

27 Oligopoly and Economic PerformanceWith the exception of the contestable-markets model, all the models of oligopoly we have examined lead us to conclude that concentration in a market leads to pricing above marginal cost and output below the efficient level.Industrial Concentration and Technological ChangeOne of the major sources of economic growth and progress throughout history has been technological advance.Several economists, notably Joseph Schumpeter and John Kenneth Galbraith, argued in works now considered classics that industrial concentration, where a relatively small number of firms control the marketplace, actually increases the rate of technological advance.

28 Herfindahl- Hirschman IndexThe Role of GovernmentRegulation of MergersCeller-Kefauver Act Extended the government’sauthority to control mergers.Herfindahl-Hirschman Index (HHI) An index ofmarket concentration found by summing the square of percentage shares of firms in the market.TABLE Calculation of a Simple Herfindahl-Hirschman Index for Four Hypothetical Industries, Each with No More Than Four FirmsPercentage Share Of:Herfindahl- Hirschman IndexFirm 1Firm 2Firm 3Firm 4Industry A50-= 5,000Industry B8010= 6,600Industry C25= 2,500Industry D4020= 2,800

29 What is the Herfindahl-Hirschman Index (HHI) for an industry in which five firms each control 20% of the market?a. 20b. 100c. 2,000d. 5,000

30 What is the Herfindahl-Hirschman Index (HHI) for an industry in which five firms each control 20% of the market?a. 20b. 100c. 2,000d. 5,000

31 The Role of Government Regulation of Mergers FIGURE Department of Justice Merger Guidelines (revised 1984)

32 The Role of Government Regulation of MergersTABLE 14.3Industry DefinitionSome Sample HHIsBeer3,525Ethanol326Las Vegas gaming1,497Critical care patient monitors2,661actions by a group of firms that are profitable for each of them only as the result of the accommodating reactions of others. This behavior includes tacit or express collusion, and may or may not be lawful in and of itself.

33 The Role of Government A Proper Role?Certainly, there is much to guard against in the behavior of large, concentrated industries. Barriers to entry, large size, and product differentiation all lead to market power and to potential inefficiency. Barriers to entry and collusive behavior stop the market from working toward an efficient allocation of resources.